We've discussed before here at The Money Game what we like to
call The
China Weak Spot, ie. the massive off-balance sheet lending
game happening between Chinese banks and trust companies.

They've colluded to exploit a loophole in Chinese regulations,
allowing them to create more loans than the government wants
created.

This weak spot is to us an even greater potential risk than the
nation's property market, though it's intertwined with the
nation's property market risk as well, given that a property
crash could expose a mass of bad loans within China's financial
system, many perhaps off-balance sheet.

Well the Chinese government has now announced that it wants
off-balance sheet loans to be brought onto banks' balance sheets.
This could mean that Chinese banks will need to raise substantial
amounts of capital, since a significant proportion of off-balance
sheet lending could be comprised of bad loans.

The move may increase pressure for capital-raising at
Chinese banks, which Fitch Ratings last month said had more than
2.3 trillion yuan ($339 billion) of off-balance sheet
assets. It also underscores concerns about the health of
the banking industry after a person with knowledge of the matter
said regulators last month ordered lenders to conduct stress
tests to gauge the impact of home prices falling as much as 60
percent.

The regulator’s order “will plug the loophole that more and more
banks now employ to get around government lending curbs,” said
Liao Qiang, a Beijing-based analyst at Standard & Poor’s.
Bringing loans back on to the balance sheet will restrict
banks’ ability to expand lending while “their capital requirement
will increase,” Liao said.

Larger banks will be required to maintain the mandated capital
adequacy ratio of 11.5 percent after taking the off-
balance-sheet loans back onto their books, the people with
knowledge of the matter said. Smaller Chinese lenders are
required to meet a 10 percent ratio.

One has to give the government credit for trying to push this
problem into the open, rather than trying to ignore it and sweep
it under the rug. Thing is, as banks are forced to come clean
with the true state of their balance sheets, we could see some
very ugly financial situations emerge.

The move will also act as a headwind for Chinese growth, given
that banks may find their lending suddenly restricted by far
lower capital adequacy ratios than previously reported. (Given
that they are forced to maintain minimum rations, as described in
the excerpt above)